Sir Winston Churchill once told French President Charles de Gaulle, “This is something you ought to know: each time we have to choose between Europe and the open sea, we shall always choose the open sea”.
Clearly, pollsters, pundits, and punters also ought to have known this. Markets were lulled into a false sense of confidence ahead of Thursday’s vote against the European Union, and the resulting shock continues to reverberate across global asset classes. Stock indexes, interest rates, and currencies are suffering through a second round of aftershocks today, with trillions of dollars in wealth destroyed over the past few trading cycles as investors respond to growing uncertainty. Traders continue to sell first and ask questions later.
We would suggest that the global economic cycle has entered into a new, more dangerous phase, with risks emerging along a number of economic, political and financial dimensions.
– A vote on European Union membership was held on Thursday 23 June, and “Leave” won by 52% to 48%. The referendum was decisive, with turnout at 71.8% and more than 30 million people voting.
– The pound sterling suffered its biggest one-day selloff on record, plunging to 1985 levels in the hours after the announcement, before rebounding to levels established prior to the killing of MP Jo Cox a week before the vote.
– Contagion spread throughout international markets, wiping more than $2 trillion off global equity prices through the course of Friday’s trading.
– David Cameron announced his resignation and stated that he plans to continue as Prime Minister until the Conservative Party’s leadership election on October 2nd. Cameron said that the formal process of providing the UK’s notice of exit to the EU (invoking Article 50 of the Lisbon Treaty) should begin under his successor.
– Former London Mayor Boris Johnson, the primary backer of the “Leave” campaign, and Home Secretary Theresa May, who backed “Remain” emerged as the front-runners in the race to replace him.
– Over the weekend, political turmoil also hit the opposition Labour party, with leader Jeremy Corbyn facing calls to resign. 23 out of 31 Members of Parliament have quit, and more than half of the shadow cabinet have walked out so far.
– Discussions began in Northern Ireland, Scotland, and Gibraltar about the possibility of splitting from the United Kingdom while remaining within the European Union.
– In an interview, Boris Johnson said, “It is clear now that ‘Project Fear’ is over, there is not going to be an emergency budget, people’s pensions are safe, the pound is stable, markets are stable, I think that is all very good news”
– French finance minister Michel Sapin said “Should Britain go quickly? Yes. France, like Germany, thinks that Britain voted, Britain voted for Brexit, and the Brexit should be put in place starting now”.
– The leaders of Germany, France, and Italy agreed that there can be no negotiations with Britain on the country’s departure from the European Union until London has formally declared its intention to quit. German Chancellor Angela Merkel said, “we agree there will be no formal or informal talks” until Article 50 has been invoked.
– Lack of clarity on the political process knocked over a series of dominoes in global financial markets, triggering a renewed selloff in equities, currencies, and risk-sensitive assets.
– Standard & Poor’s stripped the UK of its top credit grade, downgrading the country’s sovereign rating by two notches, from AAA to AA, saying the vote is a “seminal event” that “will lead to a less predictable, stable and effective policy framework”. This action was soon followed with similar actions from Moody’s and Fitch Ratings.
– A number of companies, including Foxton’s and British Airways joined most major UK-domiciled banks in issuing profit warnings for the year ahead.
-In an apparent response to deteriorating conditions, China’s central bank weakened the yuan’s fixing almost one percent to a five-and-half-year low against the dollar – marking the biggest downward move since last August.
– Carnage resumed in the currency markets, driving sterling down another 3.7% – below Friday’s low. A full-fledged flight to safety got underway once more, propping up the dollar, yen, and franc against most other majors. Emerging market and commodity-linked units fell throughout the trading session and remain on the defensive as we go to pixels.
– In the near term, UK gross domestic product will almost certainly fall, with near-recession conditions likely to prevail into early 2017. At the same time, currency depreciation will improve the export sector’s competitiveness, while reducing import volumes – reducing a trade deficit that has grown to unprecedented levels in recent years.
– EU growth will also potentially suffer a slowdown, with diminished trade and lower investment expected to reduce growth through the coming two years.
– Major central banks are likely to announce additional liquidity-boosting measures in the coming weeks and months, with the Bank of England poised to ease policy through a rate cut, additional corporate bond purchases and a potential expansion in funding for lending. Across the Channel, the European Central Bank could boost asset purchases under existing programmes in the near term, and might consider an overall increase in the event that disinflationary pressures rise.
– Impact will ripple through the US economy as well, but should be counteracted by stronger domestic fundamentals. At most, we expect growth to soften by a quarter-point through the remainder of the year. The effect on the global economy is also likely to be fairly minimal, with the bulk of net new growth already coming from areas outside Europe.
– Crude oil markets will most likely continue to take direction from the fundamental demand and supply convergence that is occurring – our view is that prices will remain within a relatively broad range around the $50 mark, without a return to the trending behaviour that has been evident in recent years.
– Emerging market and commodity-linked currencies are likely to underperform for a few months, but should stabilize into the autumn as central banks depress interest rates and engage in further quantitative easing.
– To dissuade restive domestic populations, European policymakers are likely to take a tough line in public forums over the coming months and years, threatening to make Britain’s withdrawal as painful as possible. News media will dutifully repeat these statements; prompting doomsday predictions from the punditry, and triggering further market volatility.
– Behind closed doors however, we expect that bureaucrats will engage in a series of negotiations on trade rules, the results of which will be buried far from the view of the general public in the airless and detailed language of smaller multilateral agreements. The UK will seek to reestablish access for its financial sector, while the EU will do the same for its merchandise exports – ultimately leading to a framework not substantively different than what exists today.
– Political risk will remain a fixture of financial markets for the foreseeable future, with opposition parties in France, Italy, the Netherlands, and Spain continuing to gain ground against established interests. Periodic market crashes are likely for years to come, afflicting areas of the European Union in particular.
– In an ironic twist, this level of voter hostility means that leaders are also likely to abandon so-called austerity programmes, with parties finally achieving unity in choosing to bribe populations with fiscal stimulus projects. While the long-term sustainability of this is certainly in question, there is a strong possibility that European consumption levels begin to climb in the months to come.
– Counter-intuitively, it could be argued that the markets may have helped to trigger Brexit. In convincing other participants and the media so thoroughly that the Stay vote would ultimately prevail, investors may have lulled Remain voters into staying home on the referendum date. Should this pattern be observed in other instances, we would suggest approaching market positions with extreme caution.
– Brexit also carries important lessons for participants in North America in particular, where markets seem to be assuming the victory of a centrist Hilary Clinton over Donald Trump. If the last two weeks have taught us anything, it is that the silent majority often doesn’t arrive at the polling booth. The race for the presidency could be much more unpredictable and have a far larger impact than is currently expected.
Taken in sum, we believe that the panic currently gripping markets is likely to pass within weeks, if not days. Attractive hedging opportunities are emerging for those companies willing to sell some degree of participation in further gains – particularly for those that naturally purchase sterling, euro, or emerging market units.
That said of course; there is only one way to effectively navigate the ocean of cross-currents that are likely to drive currency market outcomes this year – build a risk management strategy and stick to it. Reacting to developments after the fact is both dangerous and costly, so it is important to adopt the most disciplined approach possible.
As that most famous of Englishmen once put it;
“There is a tide in the affairs of men,
Which taken at the flood, leads on to fortune.
Omitted, all the voyage of their life is bound in shallows and in miseries.
On such a full sea are we now afloat.
And we must take the current when it serves, or lose our ventures”.
To discuss your strategy, please reach out to our trading teams – we’d love to hear from you.
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